Why India is economically vulnerable to negative forces

India in 2013 looks more like a country that has lost its glory than like a country that is supposed to show rapid economic advancement. In fact, economically India is in the most vulnerable situation since 1991 when the country pledged its gold reserves with the International Monetary Fund (IMF) for an emergency loan.

The bright spot in all this is that India undertook path breaking reforms in early 1990s led by Prime Minister Manmohan Singh, who was the FM then, and the country is now looking to embrace hard economics to bring it out of the mess it is in at present.

[caption id=“attachment_647843” align=“alignleft” width=“380”] India has no choice but to embrace austerity, prick the real estate bubble and enforce tax compliance. Reuters[/caption]

India has no choice but to embrace austerity, prick the real estate bubble and enforce tax compliance. If the country wants to avoid a nosedive of the equity and currency markets and rising bond yields, it must act now. The budget 2013-14 can be seen as recognition of the vulnerability of the country at present to both global and domestic factors. The FM has rightly given a path towards lowering deficits but much more requires to be done to get the country out of the woods.

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Why is India so vulnerable to negative economic forces at present? On the external front, the rupee is trading just 3.5 percent off its all-time lows at Rs 55 to the dollar. The current account deficit (CAD) at all time highs of 4.6% of GDP has pulled down the value of the rupee. The government is depending on FII flows to plug the CAD and that is making the country vulnerable to external shocks.

The US government’s spending cuts and the US Federal Reserve’s (Fed) withdrawal of stimulus are clear negatives for the rupee. The US spending cuts have started with $85 billion of cuts commencing in March 2013 though the Fed’s withdrawal of stimulus is still sometime away despite reservations of some of its members on the stimulus. The Fed is buying $85 billion a month of bonds to shore up the US economy.

The rupee is also vulnerable to a weak eurozone that can bring down the euro and cause economic instability in many parts of the eurozone. The rupee is also vulnerable to Japan going easy on stimulus. The rupee is vulnerable to rising oil prices and geo political tensions in the Middle East and other parts of the globe. In short, India does not have a buffer to withstand external shocks given its high current account deficit (CAD).

India’s foreign exchange reserves at $295 billion do not give much solace in the face of external shocks as it has to be seen in terms of an absolute CAD of around $85 billion. The RBI cannot use its reserves to fund the deficit, as it will make the country even more vulnerable to external shocks.

On the domestic front monsoon failure, political instability and unsustainable rise in prices make country extremely vulnerable economically. Monsoon failure will push up food inflation that is already causing the Consumer Price Index (CPI) to trend at double-digit levels. Political instability could lead to poor economic policies that can weaken the country further.

Unsustainable rise in prices will again lead to economic chaos as it will lead to a fall in the rupee and Sensex and rising bond yields, resulting in a sharp slowdown in economic growth.

Recent reports on global real estate suggest that prime commercial real estate is one of the most expensive in the world. High commercial real estate prices make the country economically unviable to do business in and genuine investors will baulk at investing in India.

India is clearly in a property bubble where real estate prices are rising against all odds. Sharp slowdown in economic growth from levels of 8.4 percent seen in 2010-11 to levels of 5 percent in 2012-13, rising interest rates, lack of banking system liquidity and weak capital markets have not affected real estate prices.

Even China is pricking its real estate bubbles despite many Chinese officials being seen as beneficiaries of high property prices.

The FM gave out a statistic that is at best can be described as deplorable. There are only 48,200 Indians who declare income of Rs 1 crore and above. The people in the streets of India will have witnessed the sudden rise in the number of Mercedes, BMWs, Audis, Jaguars, Range Rovers and other luxury vehicles on the roads and that should signify a rising number of citizens earning Rs 1 crore and above.

Greece is one example of a country where its citizens did not pay taxes and the country is suffering now for that. India is no exception where tax avoidance cannot impact the economy.

The current FM and the future one (post 2014 elections) have their task cut out to shore up India economically. Until then, one can only hope that external and internal shocks will not act up.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors